Sunday 15 November 2009 19.05 EST
First published on Sunday 15 November 2009 19.05 EST

Hang out the bunting. Prepare for the street parties. Wave the union flags. After six long quarters of recession, Mervyn King emerged from his bunker and declared that the war was over. VR Day – victory over recession – had arrived at last.

That, at least, was the interpretation some commentators put on forecasts for the economy published by the Bank of England last week. The struggle has been long. The struggle has been hard. The strategy has been costly. But in the end a battle-hardened nation emerged victorious. It is May 1945 all over again.

In economic terms, this has been a case of total war. Ultra-low interest rates, quantitative easing and record budget deficits have been mobilised against the forces of darkness.

When output shrank by 1.8% in the final quarter of 2008, and by a record 2.5% in the first quarter of this year, it felt like an economic Dunkirk. At that time, all the UK had to look forward to was blood, sweat and tears: unemployment above three million by the end of the year, a fresh round of bank collapses, the start of a second Great Depression.

But cash for clunkers has brought forward spending on cars; lower interest rates have led to a sharp reduction in monthly home-loan repayments; government pressure on mortgage lenders is helping to put a cap on home repossessions. Activist economic policy has worked. Consumer confidence is on the up. Unemployment is rising far more slowly than expected. Output will expand in the current quarter for the first time since early 2008.

Downbeat

It has to be said, though, that King appeared remarkably downbeat about the state of the nation at the press conference for last week's Inflation Report. He was not so much the Churchill standing on the balcony of Buckingham Palace on VE Day as the Churchill of November 1942, declaring after El Alamein that victory was not the end, or even the beginning of the end, but the end of the beginning. The worst was over, the governor said, but there was a long, hard road ahead.

With the banking system still dysfunctional, that seems like a reasonable call. Businesses seem in no hurry to invest more, and the fragility of consumer demand in the US and Europe suggests that hopes of an export-led recovery will be dashed. Nor is the message from the labour market unambiguously good. Unemployment has risen during the recession, but not by nearly as much as might have been expected given the fall in output. What has happened is that workers have accepted pay freezes rather than lose their jobs. Employers have hoarded labour, accepting that there will be a hit to productivity in the short term. But as demand recovers, firms will have no need to hire more staff; they will simply make their existing workforce do more. The UK faces a jobless recovery and a continued squeeze on wages as companies try to cut costs and rebuild profit margins. Real disposable incomes are going to be squeezed, and that will bear down on consumer spending. Given that consumer spending accounts for about two-thirds of GDP, it is hard to see why the economy should be growing at 4% a year by late 2010, which is what Threadneedle Street's forecasts imply. King appears less sanguine about the prospects for the economy than his colleagues on the monetary policy committee, and analysts have been speculating that the MPC was divided over whether to expand quantitative easing at its meeting this month.

All will be revealed when the minutes of that meeting are published on Wednesday. Certainly, one might ask why the MPC felt the need to boost money creation by an extra £25bn if it thinks the 6% decline in output over the past six quarters will be made up over the next 18 months.

Indeed, if the Bank's forecasts are right, it may soon be time to recall another British second world war disaster: the loss of Singapore to the Japanese. After Pearl Harbor, Churchill was sure that Singapore, with its huge naval guns pointing out to sea, was impregnable. But the guns only pointed in one direction and were no use when the Japanese attacked from the rear.

For the Japanese in 1942, read inflation in 2010. The assumption is that the spare capacity in the economy left by six quarters of falling output means that the UK can have a prolonged period of 3-4% annual growth without overheating. Threadneedle Street sees inflationary pressures remaining muted; it sees deflation as a bigger threat.

Disaster

Yet, as Jamie Dannhauser of Lombard Street Research noted last week, inflation in the UK has continued to be stronger than expected, in contrast to the US, the eurozone and Japan.

One reason inflation has not fallen further as the economy has contracted by almost 6% is that the pound has depreciated by 25%, making imports dearer. But price pressures in the service sector – which tends to be relatively well insulated from movements in sterling – are stubbornly high, suggesting that the UK remains an inflation-prone economy.

It is perhaps understandable that policymakers want to be absolutely certain the economy is in full recovery mode before removing the stimulus. This, though, was precisely the error that Alan Greenspan made earlier this decade when he cut US interest rates to 1% following the collapse of the dotcom bubble and left them at the same rock-bottom level for two years. Greenspan did not start tightening policy until he was confident recovery was in the bag, but by that stage he had created the conditions for an even bigger bubble – this time in the housing market.

Monetary policy does not work overnight, as the MPC knows full well. If the economy really is going to pick up steam during 2010 – which is what Threadneedle Street's forecasts suggest – the MPC should already be thinking about when and how to start removing the stimulus. Indeed, some might argue it is already cutting things a bit fine.

The final scenario is neither Dunkirk nor VE Day but something far messier. The global economy has received a profound shock in the past few years, and the response has been unprecedented. Even assuming there are no disasters lurking out there (a big assumption), the chances of a linear, robust, inflation-free recovery look slim. All battle plans have to be revised once the shooting starts, and the risk of the economic generals being surprised by an unforeseen danger is considerable. King is right to be wary. This war is far from over.